Pay Down Debt or Save for a Rainy Day: Which Should You Do First?

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Millions of Americans have outstanding debt and limited savings. So when a rare bit of spare cash appears -- say, for example, a tax refund -- they face a tough question: Should they use it to pay down their debt, or save it in an emergency fund or for a long-term goal like retirement or buying a house?

The right answer is a bit more complicated than you might think -- it depends on the type of debt you have and what you plan to do with your savings.

But it's not hard to determine which is the smartest decision to fit your situation.

What People Are Doing With Tax Refunds

For many people, tax refunds represent their biggest fiscal windfall of the year, and this year more people will use their refunds to pay down debt rather than to save. According to a survey from dealnews.com, 44 percent of taxpayers getting a refund expect to use it to pay debts, compared to 34 percent who plan to save it. The results show a rising appreciation for financial responsibility: Only 22 percent said they would spend their tax refund.

To figure out whether you're better off saving a windfall or using it to pay down your debt, there are a few things you need to look at more closely. Once you have answers to the following questions, you'll be able to make a smarter decision.

Question 1: What Interest Rate Are You Paying on Debt?

From a purely financial standpoint, the more you're paying in interest charges on your debt, the more you gain by paying it off.

In general, you can break down what you owe into "good debt" and "bad debt" based on its interest rate and repayment terms. For instance, most credit-card debt gets treated as bad debt, because prevailing interest rates on credit cards are very high -- typically well above 10 percent, and often above 20 percent. By contrast, mortgage debt is often good debt, because rates right now are extremely low, and most people can deduct the interest they pay on their mortgages on their tax returns.

With some types of debt, though, the distinction isn't always as clear.

Some promotional car loan rates can be very low, for instance, while other sources can charge much higher interest rates. Similarly, student loans come in different flavors, with federally subsidized loans typically offering better rates than private loans.

Whatever you do decide to put toward paying down debt should almost always go toward the highest-rate debt you have so it will make the biggest positive impact on your finances.

Question 2: What Return Can You Expect to Earn on Your Savings?

The other half of the debt/saving question is how much of a return you'll earn on what you save. If you plan to put money into an emergency fund or rainy-day account at a bank or credit union, you won't get much income at all right now. That said, if you don't have any money set aside to help you weather an emergency, parking some of that extra cash in savings is an insurance policy against having to put charges on a high-interest credit card later.

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If you're planning to invest your savings, however, the picture is much different. With the stock market having more than doubled over the past four years, those who bought stocks in 2009 rather than paying down debt have generally done much better. But looking ahead, it's unlikely that stocks will keep posting such strong returns, especially with the markets having recently set new all-time highs.

Question 3: Do You Have Extra Incentives to Save or Pay Down Debt?

In some cases, there'll be added reasons to make one choice over the other.

On the debt side, some lenders offer discounts if you make additional payments or pay off a loan early, giving you a financial incentive to put extra cash toward debt. Also, paying down debt can improve your credit score, which in turn can make it easier for you to qualify for cheaper financing in the future or to save money on insurance premiums and other expenses.

On the saving side, many employers offer matching contributions for those who contribute to retirement accounts at work. Combined with the tax savings from saving for retirement, an employer match can give you a nice boost for your savings dollars.

Look closely at whether you have any such incentives, and be sure to weigh them in your decision.

Find Your Balance

Of course, the decision to pay down debt or save doesn't have to be an all-or-nothing proposition. Splitting the difference can give you the benefits of both courses of action. In the end, much of the decision depends on whether getting rid of debt will make you feel more financially secure than having it hanging over your head, even with savings to offset it.

Looking for advice on how to get out of debt? Take the "Getting out of Debt" course through our Learning Center. It's free and takes less than 10 minutes to complete. To see all the personal finance courses we have to offer, click here. Also check out our courses on investing!